For most company managers, when compared to the more easily understood production and profitable sale of goods, FX risk management has an image problem. It is more theoretical, more esoteric and lacks the glamour of sales. It originates from the concept of the prevention of loss, rather the more alluring area of revenue generation.
However, in terms of adding to the bottom line, it is not the poor cousin compared to sales. And if neglected, it will negate the effort of an otherwise successful sales campaign.
One way to ensure that everyone gets this clear message, is to establish risk management metrics. These are essential if risk management activities are to be measured and adapted if required. It also ensures that the finance group does not suffer under unrealistic expectations.
A metric is a number which measures performance. A benchmark, or standard, is how it is determined whether the performance measured is acceptable. It is important to know that a metric is useless until it is compared to a performance standard. Performance metrics are often referred to in the corporate world as Key Performance Indicators, or KPIs for short.
KPIs can follow the “SMART” criteria: Specific purpose, Measurable, Achievable, Relevant and Time-phased. These are the value, or outcomes for a specific, relevant period.
Useful KPI concepts to consider when developing your own metrics include choosing leading versus lagging indicators (leading indicators let you fix things before they get worse) and dashboards (graphic displays which show at a glance where the trouble spots occur, including say by currency, region, or entity).
But, as a general rule, the fewer KPIs tracked the better. Some of the more useful metric categories include: 1. reducing operating flow volatility (for example income and expenses); 2. reduction of risk (from a statistical view); and, 3. reduction in cost of hedging.
Taking each of these three in turn, lets first look at metrics for reducing volatility. These might include net revenue variance and EPS attributable to FX. The latter metric is gaining wide acceptance and is often included in quarterly earnings reports. One common benchmark for this metric is keeping EPS (attributable to FX) to less than 0.01/share.
For risk reduction metrics, these might include scenario testing, probabilistic earnings at risk and net gain/loss on contracts versus. exposures. Hedge effectiveness is also a strong risk reduction metric.
For reduction of cost metrics, we have ones for the reduction of cost of hedging including total volume of hedge contracts, total points and premiums paid as a percentage of hedge nationals and FX counterparty bidding performance.
Metrics and benchmarks – together with statistical, or numeric stress testing descriptions – should be a key element of a company’s FX hedging policy, sitting alongside exposure limits, hedge ratios, and acceptable instrument lists.
The measurement basis should be specified to ensure everyone being consistent. For example, will the numbers be based on GAAP accruals, or pure economic cash flows? Pre, or post-tax? Is the hedging implemented to protect parent company operating income, or foreign subsidiary local currency operating income? And it is over single periods, or multiple periods?
There is a strong case for benchmarks, but, very importantly, they have to be realistic benchmarks. A classic FX risk management error is to measure success by whether the hedge made money.
This error is particularly common when bench-marks have not been formally established and completely ignores the relationship between the hedge, and the underlying exposure.
Other unfair metrics include achieving a particular budget rate, or using last year’s rate. These are unfair because while they may be desirable, they are unachievable.
The risk portfolio definitions need to be considered. For example, most corporate risk management involves hedging a portfolio of transactions. However, transactions can be actual, or forecast. With forecast transactions, there is always concern about forecast accuracy. One way to manage that risk fairly, is to divide the transactions into those that a team are highly confident of and those they are not. Different metrics should apply to each group.
Finally FX risk management metrics and their associated benchmarks create accountability. For their continued effectiveness, they must be reviewed regularly, and adapted as policies and results diverge.